Allied Capital Under Scrutiny Over $9 Million Transaction

By KURT EICHENWALD

Published: April 27, 2004

A $9 million transaction at the nation's largest business development company has led to questions on Wall Street about the quality of its financial statements and to an informal inquiry by federal securities regulators.

But the company, the Allied Capital Corporation, says that the 2003 transaction with a related entity was both immaterial and irrelevant and did nothing to affect the financial status of either business. For that reason, a company executive said, details of the transaction -- which involved the transfer of defaulted loans to Allied from Business Loan Express, the largest company in its investment portfolio -- were not specifically disclosed.

The transfer was done as part of an oral agreement between the companies.

The transaction emerged as an issue yesterday when Joel Houck, an analyst at Wachovia Securities, wrote in a report that he was dropping coverage of Allied because of concerns about poor disclosures related to the loan transfer.

''We believe the financial statement is inadequate,'' Mr. Houck wrote in the report, saying that his unease pertained to the 2003 transaction. ''In our opinion, management's response to requests for additional financial disclosure has been unsatisfactory.''

Mr. Houck did not return a phone call seeking comment.

Shares of Allied Capital fell 54 cents yesterday, to $25.40.

The loans at issue were transferred from Business Loan Express, or BLX, which provides financing as a qualified lender for the federal Small Business Administration. BLX is more than 90 percent owned by Allied Capital, and pays the company streams of cash, including dividends based on its after-tax income.

Under the transaction in question, in February of last year, BLX shifted $9 million worth of troubled and defaulted loans to Allied as payment for money it owed the larger company. The loans were transferred at their full face value, with interest.

Documents pertaining to the transaction were filed late last year by Allied during the bankruptcy proceedings of one of the small borrowers, Trilogy Conifer. In recent weeks, analysts said, the documents began circulating among investors and on Wall Street.

The reason for the concern about the documents was simple: defaulted and troubled loans are not worth their full value; indeed, under most lender accounting, a defaulted loan must have its value reduced in the company's books. That decline in value is then usually accounted for by a reduction in the lender's profits.

In other words, by counting the loans at full value, the transaction raised concerns among some investors both that the income of BLX had been manipulated upward -- raising dividend payments to Allied -- and that it may be a signal of other undisclosed related-party transactions.

But Joan M. Sweeney, a managing director of Allied Capital, said that the concerns were misplaced.

''We have never entered into any transaction with a portfolio company in order to distort its earnings ability or value,'' she said. ''We have not taken any other loans back from BLX, nor do we have any agreements to do so.''

The problem resulted because the transaction was an insignificant event that had been misunderstood by Wall Street, she said.

The loans in question were originally issued by another Allied subsidiary before the company's acquisition of its stake in what became BLX in late 2000, Ms. Sweeney said. The management of BLX did not want the loans. So they were placed with BLX under an oral agreement that they could be shifted back to Allied if their credit quality deteriorated further, she said. There was no disclosure of the oral agreement, Ms. Sweeney said, because it involved a few million dollars in a deal worth many times that.

The placement of the loans with BLX resulted in its owing debt to Allied equal to the loan value. In 2003, Ms. Sweeney said, Allied decided to recapitalize BLX; as part of that deal, BLX invoked the oral agreement and transferred the loans back to Allied in exchange for the cancellation of the related debt.

In the end, she said, the transaction had no effect on the value of Allied's stake in BLX.

''These were loans that were originated by a prior management team, and we had agreed to take them back,'' she said. ''Any loss that would have been incurred on these loans would not reflect on the earnings quality or credit quality of the company.''

When Mr. Houck of Wachovia began questioning the loans last week, the company was unable to provide full answers because of the federal rules against selective disclosure, Ms. Sweeney said. Instead, Allied is planning to address questions about the transaction in its quarterly earnings conference call tomorrow.